Banks and Business Cycles

I construct a dynamic general equilibrium model where a recession is initiated by losses suffered by financial institutions, and exacerbated by their inability to extend credit to the real economy. The event that triggers the recession is similar to a redistribution shock: a small sector of the economy -- borrowers who use their home as collateral -- defaults on their loans (that is, they pay back less than contractually agreed). When banks hold little equity in excess of regulatory requirements, their porfolio losses require them to react immediately, either by recapitalizing or by deleveraging. By deleveraging, banks transform the initial redistribution shock into a credit crunch, and, to the extent that some firms depend on bank credit, amplify and propagate the financial shock to the real economy. In my benchmark experiment aimed at replicating key features of the Great Recession, credit losses (that is, a redistribution shock) of about 5 percent of total GDP lead to a 3 percent drop in output, whereas they would have little effect on economic activity in a model without financing frictions where banks are just a veil.